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China banker speaks on capital convertibility

ZhouXiaochuan

BEIJING (Caixin Online) — The Communist Party’s 18th National Congress generally addressed approaches to institutional reforms of the financial system. To assist, the central bank has started spelling out relevant details that can be used in a grand plan for the future.

This article discusses one of those details: What capital account convertibility means with regards to proposals raised at the 18th party congress aimed at gradually achieving yuan capital account convertibility.

Defining convertibility

There is no clear, internationally-recognized definition of capital-account convertibility. It’s unlike current-account convertibility, for which the International Monetary Fund charter sets clear, defined standards in Article VIII. China committed to Article VIII in 1996, and since then has formally implemented current-account convertibility.

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The substance of the commitments and targets needed to achieve current-account convertibility are very clear. There are also consulting and verification mechanisms. But no authoritative institution has clearly defined capital-account convertibility, or formulated clear standards. Thus, without a clear definition, the concept of capital-account convertibility is relatively vague.

The IMF, for technical reasons, divides capital-account convertibility into seven categories, which comprise 40 items, ranked according to importance.

Not completing some smaller items doesn’t carry much significance. Whether capital-account convertibility has been achieved is determined by looking at whether most of these 40 items have been completed. If they have, it counts as capital-account convertibility.

Because there is no clear definition of capital-account convertibility, there have been some misunderstandings. One relatively influential misunderstanding involves the idea that capital-account convertibility is based on a so-called “four-in-one” combination of four factors: a free-floating exchange rate, cross-border capital flows without controls, free currency exchange for financial market transactions and international acceptance of a home currency.

Judging by the 40 items listed by IMF in its qualifications for capital-account convertibility, one can find that China’s currency is already convertible to a high degree. We aren’t far from the goal now.

Let’s first consider a free-floating exchange rate. Some people think an exchange rate must float freely to achieve convertibility. In fact, while these factors are related, they should still be appropriately distinguished.

For example, Hong Kong pegs its currency to the U.S. dollar and thus doesn’t have a free-floating exchange rate. But the Hong Kong dollar
USDHKD, -0.03%
is one of the world’s most freely-converted currencies. One can see that the two issues aren’t equivalent.

The second factor is cross-border capital flows without controls. Among the world’s major powers, there has never been complete liberalization for cross-border capital transfers. Most countries have ways to combat money laundering and terrorist financing.

The G20 meeting in London imposed tax haven restrictions so that tax dodgers are managed very closely. Meanwhile, the United States has leveled financial sanctions on certain countries. If all capital flows were free, could a country impose these sorts of restrictions and sanctions? Clearly, cross-border capital flows aren’t completely free.

The third point concerns the ability to exchange various currencies (mainly hard currency) for capital transactions, including the degree of freedom, market depth and price differences tied to these exchanges.

Many countries restrict and monitor non-citizen bank accounts and have certain requirements on cross-border capital transfers (regardless of currency). But the transferred capital enjoys relatively free convertibility and is allowed to be exchanged to currencies already available on the domestic market.

Why no one will win the currency war

(7:12)

With Japan, China and the U.S. all pursuing weak-currency policies, other major economies are retaliating.

The currencies of many small open economies aren’t international currencies, even though they have achieved convertibility (an exception is the Swiss franc
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). On the contrary, China has not achieved capital-account convertibility, but steps toward the internationalization of the yuan
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have been undertaken and have been welcomed by many.

These four concepts cannot be inextricably connected. Doing so would make the progress difficult. Moreover, there is no reason why they have to be achieved at the same time.

Restrictions needed

Capital-account convertibility rarely leads to a complete lack of restriction. But most activities can be free even if some are restricted. This isn’t to say that convertibility isn’t allowed, but rather than it must be handled by the rules.

Most countries that have achieved capital-account convertibility today continue to manage capital flows. And the IMF has said emerging countries can restrict capital flows in certain ways.

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